Full file at ://fratstock.eu/sample/Test-Bank-Principles... · Full file at Chapter 2 Financial...

Full file at https://fratstock.eu

Chapter 2

Financial Statements and Analysis

Learning Goals

1. Review the contents of the stockholders’ report and the procedures for consolidating international

financial statements.

2. Understand who uses financial ratios, and how.

3. Use ratios to analyze a firm’s liquidity and activity.

4. Discuss the relationship between debt and financial leverage and the ratios used to analyze a firm’s

debt.

5. Use ratios to analyze a firm’s profitability and market value.

6. Use a summary of financial ratios and the DuPont System of analysis to perform a complete ratio

analysis.

True/False

1. The Financial Accounting Standards Board (FASB) is the federal regulatory body that governs the

sale and listing of securities.

Answer: FALSE

Level of Difficulty: 1

Learning Goal: 1

Topic: Accounting Standards and Regulation


2. GAAP is the accounting profession’s rule-setting body.

Answer: FALSE


Learning Goal: 1


3. Generally-accepted accounting principles are authorized by the Financial Accounting Standards

Board (FASB).

Answer: TRUE


Learning Goal: 1



4. Publicly-owned corporations are those which are financed by the proceeds from the treasury

securities.

Answer: FALSE


Learning Goal: 1


5. Publicly-owned corporations are required by the Securities and Exchange Commission (SEC) and

individual state securities commissions to provide their stockholders with an annual stockholders’

report.

Answer: TRUE


Learning Goal: 1


6. The president’s letter, as the first component of the stockholders’ report, is the primary

communication from management to the firm’s employees.

Answer: FALSE


Learning Goal: 1

Topic: Stockholders’ Report

7. Common stock dividends paid to stockholders are equal to the earnings available for common

stockholders divided by the number of shares of common stock outstanding.

Answer: FALSE


Learning Goal: 1

Topic: Dividends

8. The income statement is a financial summary of the firm’s operating results during a specified

period while the balance sheet is a summary statement of the firm’s financial position at a given

point in time.

Answer: TRUE


Learning Goal: 1

Topic: Income Statement

9. The par value of common stock is an arbitrarily assigned per share value used primarily for

accounting purposes.

Answer: TRUE


Learning Goal: 1

Topic: Balance Sheet

10. Paid-in capital in excess of par represents the firm’s book value received from the original sale of

common stock.

Answer: FALSE



Learning Goal: 1


11. Earnings per share represents amount earned during the period on each outstanding share of

common stock.

Answer: TRUE


Learning Goal: 1

Topic: Earnings

12. Net fixed assets represent the difference between gross fixed assets and the total expense recorded

for the depreciation of fixed assets.

Answer: TRUE


Learning Goal: 1


13. Earnings per share results from dividing earnings available for common stockholders by the

number of shares of common stock authorized.

Answer: FALSE


Learning Goal: 1

Topic: Earnings

14. Retained earnings represent the cumulative total of all earnings retained and reinvested in the firm

since its inception.

Answer: TRUE


Learning Goal: 1


15. The balance sheet is a statement which balances the firm’s assets (what it owns) against its debt

(what it owes).

Answer: FALSE


Learning Goal: 1


16. The amount paid in by the original purchasers of common stock is shown by two entries in the

firm’s balance sheet—common stock and paid-in capital in excess of par on common stock.

Answer: TRUE


Learning Goal: 1


17. The original price per share received by the firm on a single issue of common stock is equal to the

sum of the common stock and paid-in capital in excess of par accounts divided by the number of

shares outstanding.


Answer: TRUE


Learning Goal: 1



18. The statement of cash flows reconciles the net income earned during a given year, and any cash

dividends paid, with the change in retained earnings between the start and end of that year.

Answer: FALSE


Learning Goal: 1

Topic: Statement of Cash Flows

19. The cumulative translation adjustment is an equity reserve account on the parent company’s books

in which translation gains and losses are accumulated.

Answer: TRUE


Learning Goal: 1

Topic: International Accounting

20. The statement of cash flows provides insight into the firm’s assets and liabilities and reconciles

them with changes in its cash and marketable securities during the period of concern.

Answer: FALSE


Learning Goal: 1


21. A U.S. parent company’s foreign equity accounts are translated into dollars using the exchange rate

that prevailed when the parent’s equity investment was made (the historical rate).

Answer: TRUE


Learning Goal: 1


22. A U.S. parent company’s foreign retained earnings are adjusted to reflect gains and losses resulting

from currency movements as well as each year’s operating profits or losses.

Answer: FALSE


Learning Goal: 1


23. The Financial Accounting Standards Board (FASB) Standard No. 52 mandates that U.S.-based

companies translate their foreign-currency-denominated assets and liabilities into dollars using the

current rate (translation) method.

Answer: TRUE


Learning Goal: 1


24. Time-series analysis is the evaluation of the firm’s financial performance in comparison to other

firm(s) at the same point in time.

Answer: FALSE


Learning Goal: 2


Topic: Ratio Analysis Basics


25. As a rule, the necessary inputs to an effective financial analysis include, at minimum, the income

statement and the statement of cash flow.

Answer: FALSE


Learning Goal: 2


26. Cross-sectional ratio analysis involves comparing the firm’s ratios to those of firms in other

industries at the same point in time.

Answer: FALSE


Learning Goal: 2


27. Benchmarking is a type of cross-sectional analysis in which the firm’s ratio values are compared to

those of firms in other industries, primarily to identify areas for improvement.

Answer: FALSE


Learning Goal: 2


28. Time-series analysis evaluates performance of firms at the same point in time using financial ratios.

Answer: FALSE


Learning Goal: 2


29. The firm’s creditors are primarily interested in the short-term liquidity of the company and its

ability to make interest and principal payments.

Answer: TRUE


Learning Goal: 2

Topic: Liquidity Analysis

30. Benchmarking is a type of time-series analysis in which the firm’s ratio values are compared to

those of a key competitor or group of competitors, primarily to isolate areas of opportunity for

improvement.

Answer: FALSE


Learning Goal: 2


31. Ratio analysis merely directs the analyst to potential areas of concern; it does not provide

conclusive evidence as to the existence of a problem.

Answer: TRUE


Learning Goal: 2



32. In a cross-sectional comparison of firms operating in several lines of business, the industry average

ratios of any of the firm’s product lines may be used to analyze the multiproduct firm’s financial

performance.

Answer: FALSE


Learning Goal: 2


33. Due to inflationary effects, inventory costs and depreciation write-offs can differ from their true

values, thereby distorting profits.

Answer: TRUE


Learning Goal: 2


34. If an analysis is concerned only with certain specific aspects of a firm’s financial position, one or

two ratios may provide sufficient information from which to make a reasonable judgment.

Answer: TRUE


Learning Goal: 2


35. In ratio analysis, the financial statements being used for comparison should be dated at the same

point in time during the year. If not, the effect of seasonality may produce erroneous conclusions

and decisions.

Answer: TRUE


Learning Goal: 2


36. The use of the audited financial statements for ratio analysis may not be preferable because there

may be no reason to believe that the data contained in them reflect the firm’s true financial

condition.

Answer: FALSE


Learning Goal: 2


37. Both present and prospective shareholders are interested in the firm’s current and future level of

risk and return. These two dimensions directly affect share price.

Answer: TRUE


Learning Goal: 2



38. The comparison of a particular ratio to the standard (industry average) is made in order to isolate

any deviations from the norm. In the case of ratios for which higher values are preferred, as long as

the firm that is being analyzed has a value in excess of the industry average it can be viewed

favorably.

Answer: FALSE


Learning Goal: 2


39. The use of differing accounting treatments—especially relative to inventory and depreciation—can

distort the results of ratio analysis, regardless of whether cross-sectional or time-series analysis is

used.

Answer: TRUE


Learning Goal: 2


40. Inflationary effects typically have a greater impact the larger the differences in the age of the assets

of the firms being compared. Without adjustment, inflation tends to cause older firms (with older

fixed assets) to appear more efficient and profitable than newer firms (with newer fixed assets).

Answer: TRUE


Learning Goal: 2


41. Present and prospective shareholders and lenders pay close attention to the firm’s degree of

indebtedness and ability to repay debt. Shareholders are concerned since the claims of creditors

must be satisfied prior to the distribution of earnings to them. Lenders are concerned since the more

indebted the firm, the higher the probability that the firm will be unable to satisfy the claims of all

its creditors.

Answer: TRUE


Learning Goal: 2

Topic: Leverage Analysis

42. The liquidity of a business firm refers to the solvency of the firm’s overall financial position.

Answer: TRUE


Learning Goal: 3


43. The liquidity of a business firm is measured by its ability to satisfy its long-term obligations as they

come due.

Answer: FALSE


Learning Goal: 3



44. The current ratio provides a better measure of overall liquidity only when a firm’s inventory cannot

easily be converted into cash. If inventory is liquid, the quick ratio is a preferred measure of overall

liquidity.

Answer: FALSE


Learning Goal: 3


45. Since the differences in the composition of a firm’s current assets and liabilities can significantly

affect the firm’s “true” liquidity, it is important to look beyond measures of overall liquidity to

assess the activity (liquidity) of specific current accounts.

Answer: TRUE


Learning Goal: 3


46. The average age of inventory is viewed as the average length of time inventory is held by the firm

or as the average number of days’ sales in inventory.

Answer: TRUE


Learning Goal: 3

Topic: Activity Analysis

47. Total asset turnover commonly measures the liquidity of a firm’s total assets.

Answer: FALSE


Learning Goal: 3


48. The magnification of risk and return introduced through the use of fixed-cost financing such as debt

and preferred stock is called financial leverage.

Answer: TRUE


Learning Goal: 4


49. The less fixed-cost debt (financial leverage) a firm uses, the greater will be its risk and return.

Answer: FALSE


Learning Goal: 4


50. The higher the value of the times interest earned ratio, the higher the proportion of the firm’s

interest earnings compared to its contractual interest payments.

Answer: FALSE


Learning Goal: 4



51. In general, the more debt (other people’s money) a firm uses in relation to its assets, the smaller its

financial leverage.

Answer: FALSE


Learning Goal: 4


52. The lower the fixed-payment coverage ratio, the lower is the firm’s financial leverage.

Answer: FALSE


Learning Goal: 4


53. The higher the debt ratio, the more financial leverage a firm has and, thus, the greater will be its

risk and return.

Answer: TRUE


Learning Goal: 4


54. Typically, higher coverage ratios are preferred, but too high a ratio may indicate under-utilization

of fixed-payment obligations, which may result in unnecessarily low risk and return.

Answer: TRUE


Learning Goal: 4


55. Earnings per share represent the dollar amount earned and distributed to shareholders.

Answer: FALSE


Learning Goal: 5

Topic: Profitability Analysis

56. Gross profit margin measures the percentage of each sales dollar left after the firm has paid for its

goods and operating expenses.

Answer: FALSE


Learning Goal: 5


57. Net profit margin measures the percentage of each sales dollar remaining after all costs and

expenses, including interest and taxes, have been deducted.

Answer: FALSE


Learning Goal: 5



58. Return on total assets (ROA) measures the overall effectiveness of management in generating

profits with the owners’ investment in the firm.

Answer: FALSE


Learning Goal: 5


59. The price/earnings (P/E) ratio represents the degree of confidence that investors have in the firm’s

future performance.

Answer: TRUE


Learning Goal: 5

Topic: Market Value Analysis

60. The financial leverage multiplier is the ratio of the firm’s total assets to stockholders’ equity.

Answer: TRUE


Learning Goal: 6


61. The DuPont formula allows the firm to break down its return into the net profit margin, which

measures the firm’s profitability on sales, and its total asset turnover, which indicates how

efficiently the firm has used its assets to generate sales.

Answer: TRUE


Learning Goal: 6

Topic: Dupont System Analysis

62. The DuPont system allows the firm to break its return on equity into a profit-on-sales component,

an efficiency-of-asset-use component, and a use-of-leverage component.

Answer: TRUE


Learning Goal: 6


63. The McCain-Feingold Act of 2002 was passed to eliminate many of the disclosure and conflict of

interest problems of corporations.

Answer: FALSE


Learning Goal: 1


64. The Sarbanes-Oxley Act of 2002 was passed to eliminate many of the disclosure and conflict of

interest problems of corporations.

Answer: TRUE


Learning Goal: 1



65. The Sarbanes-Oxley Act of 2002 established the Public Company Accounting Oversight Board

(PCAOB) which is a not-for-profit corporation that oversees auditors of public corporations.

Answer: TRUE


Learning Goal: 1


66. The Sarbanes-Oxley Act of 2002 established the Private Company Accounting Oversight Board

(PCAOB) which is a for-profit corporation that oversees CEOs of public corporations.

Answer: FALSE


Learning Goal: 1


67. The average age of inventory can be calculated as inventory divided by 365.

Answer: FALSE


Learning Goal: 3


68. The average age of inventory can be calculated as inventory turnover divided by 365.

Answer: FALSE


Learning Goal: 3


69. The average age of inventory can be calculated as 365 divided by inventory turnover.

Answer: TRUE


Learning Goal: 3


70. The average payment period can be calculated as accounts payable divided by average sales per

day.

Answer: FALSE


Learning Goal: 3


71. The average payment period can be calculated as accounts payable divided by average purchases

per day.

Answer: TRUE


Learning Goal: 3



Multiple Choice Questions

1. One of the most influential documents issued by a publicly-held corporation is the

(a) letter to stockholders.

(b) annual report.

(c) cash flow statement.

(d) income statement.

Answer: B


Learning Goal: 1


2. The rule-setting body, which authorizes generally accepted accounting principles is

(a) GAAP.

(b) FASB.

(c) SEC.

(d) Federal Reserve System.

Answer: B


Learning Goal: 1


3. Accounting practices and procedures used to prepare financial statements are called

(a) SEC.

(b) FASB.

(c) GAAP.

(d) IRB.

Answer: C


Learning Goal: 1


4. The federal regulatory body governing the sale and listing of securities is called the

(a) IRS.

(b) FASB.

(c) GAAP.

(d) SEC.

Answer: D


Learning Goal: 1



5. The stockholder’s annual report must include

(a) A statement of cash flows.

(b) An income statement.

(c) A balance sheet.

(d) A statement of retained earnings.

(e) All of the above.

Answer: E


Learning Goal: 1


6. The stockholder’s report may include all of the following EXCEPT

(a) a cash budget.

(b) an income statement.

(c) a statement of cash flows.

(d) a statement of retained earnings.

Answer: A


Learning Goal: 1


7. Total assets less net fixed assets equals

(a) gross assets.

(b) current assets.

(c) depreciation.

(d) liabilities and equity.

Answer: B


Learning Goal: 1


8. The _________ provides a financial summary of the firm’s operating results during a specified

period.

(a) income statement

(b) balance sheet

(c) statement of cash flows

(d) statement of retained earnings

Answer: A


Learning Goal: 1



9. Gross profits are defined as

(a) operating profits minus depreciation.

(b) operating profits minus cost of goods sold.

(c) sales revenue minus operating expenses.

(d) sales revenue minus cost of goods sold.

Answer: D


Learning Goal: 1


10. Operating profits are defined as

(a) gross profits minus operating expenses.

(b) sales revenue minus cost of goods sold.

(c) earnings before depreciation and taxes.

(d) sales revenue minus depreciation expense.

Answer: A


Learning Goal: 1


11. Net profits after taxes are defined as

(a) gross profits minus operating expenses.

(b) sales revenue minus cost of goods sold.

(c) EBIT minus interest.

(d) EBIT minus interest and taxes.

Answer: D


Learning Goal: 1


12. Operating profits are defined as

(a) sales revenue minus cost of goods sold.

(b) earnings before interest and taxes.

(c) earnings before depreciation and taxes.

(d) earnings after tax.

Answer: B


Learning Goal: 1


13. Earnings available to common shareholders are defined as net profits

(a) after taxes.

(b) after taxes minus preferred dividends.

(c) after taxes minus common dividends.

(d) before taxes.

Answer: B



Learning Goal: 1


14. All of the following are examples of current assets EXCEPT

(a) accounts receivable.

(b) cash.

(c) accruals.

(d) inventory.

Answer: C


Learning Goal: 1


15. All of the following are examples of fixed assets EXCEPT

(a) automobiles.

(b) buildings.

(c) marketable securities.

(d) equipment.

Answer: C


Learning Goal: 1


16. All of the following are examples of current liabilities EXCEPT

(a) accounts receivable.

(b) accounts payable.

(c) accruals.

(d) notes payable.

Answer: A


Learning Goal: 1


17. The net value of fixed assets is also called its

(a) market value.

(b) par value.

(c) book value.

(d) price.

Answer: C


Learning Goal: 1



18. The _________ represents a summary statement of the firm’s financial position at a given point in

time.


(b) balance sheet



Answer: B


Learning Goal: 1


19. The _________ summarizes the firm’s funds flow over a given period of time.


(b) balance sheet



Answer: C


Learning Goal: 1


20. The statement of cash flows may also be called the

(a) sources and uses statement.

(b) statement of retained earnings.

(c) bank statement.

(d) funds statement.

Answer: A


Learning Goal: 1


21. FASB Standard No. 52 mandates that U.S. based companies must translate their

foreign-currency-denominated assets and liabilities into dollars using the

(a) Historical rate.

(b) Current rate.

(c) Average rate.

(d) None of the above.

Answer: B


Learning Goal: 1



22. Retained earnings on the balance sheet represents

(a) net profits after taxes.

(b) cash.

(c) net profits after taxes minus preferred dividends.

(d) the cumulative total of earnings reinvested in the firm.

Answer: D


Learning Goal: 1


23. The statement of retained earnings reports all of the following EXCEPT

(a) net profits after taxes.

(b) interest.

(c) common stock dividends.

(d) preferred stock dividends.

Answer: B


Learning Goal: 1

Topic: Statement of Retained Earnings

24. When preparing a statement of cash flows, retained earnings adjustments are required so that which

of the following are separated on the statement?

(a) Revenue and cost.

(b) Assets and liabilities.

(c) Depreciation and purchases.

(d) Net profits and dividends.

Answer: D


Learning Goal: 1


25. A firm had the following accounts and financial data for 2005.

Sales Revenue $3,060 Cost of goods sold $1,800

Accounts Receivable

500 Preferred stock dividends 18

Interest expense 126 Tax rate 40%

Total oper. expenses

600 Number of shares of common 1,000

Accounts payable 240 stocks outstanding

The firm’s earnings available to common shareholders for 2005 were _________.

(a) –$224

(b) $195

(c) $302

(d) $516


Answer: C


Learning Goal: 1


26. A firm had the following accounts and financial data for 2005:

Sales revenue $3,060 Cost of goods sold $1,800

Accounts receivable 500 Preferred stock dividends 18


Total operating expenses

600 Number of common shares 1,000

Accounts payable 240 outstanding

The firm’s earnings per share, rounded to the nearest cent, for 2005 was ______.

(a) $0.53

(b) $0.51

(c) $0.32

(d) $0.30

Answer: D


Learning Goal: 1


27. A firm had the following accounts and financial data for 2005.

Sales revenue $3,060 Cost of goods sold $1,800

Accounts receivable 500 Preferred stock dividends 18


Total operating expenses 600 Number of common shares 1,000

Accounts payable 240 outstanding

The firm’s net profit after taxes for 2005 was ______.

(a) –$206

(b) $213

(c) $320

(d) $206

Answer: C


Learning Goal: 1


28. On the balance sheet net fixed assets represent

(a) gross fixed assets at cost minus depreciation expense.

(b) gross fixed assets at market value minus depreciation expense.

(c) gross fixed assets at cost minus accumulated depreciation.

(d) gross fixed assets at market value minus accumulated deprecation.


Answer: C


Learning Goal: 1



29. Paid-in-capital in excess of par represents the amount of proceeds

(a) from the original sale of stock.

(b) in excess of the par value from the original sale of common stock.

(c) at the current market value of common stock.

(d) at the current book value of common stock.

Answer: B


Learning Goal: 1


30. Firm ABC had operating profits of $100,000, taxes of $17,000, interest expense of $34,000 and

preferred dividends of $5,000. What was the firm’s net profit after taxes?

(a) $66,000

(b) $49,000

(c) $44,000

(d) $83,000

Answer: B


Learning Goal: 1


31. Candy Corporation had pretax profits of $1.2 million, an average tax rate of 34 percent, and it paid

preferred stock dividends of $50,000. There were 100,000 shares outstanding and no interest

expense. What were Candy Corporation’s earnings per share?

(a) $3.91

(b) $4.52

(c) $7.42

(d) $7.59

Answer: C


Learning Goal: 1


32. A firm had year end 2004 and 2005 retained earnings balances of $670,000 and $560,000,

respectively. The firm paid $10,000 in dividends in 2005. The firm’s net profit after taxes in 2002

was _________.

(a) –$100,000

(b) –$110,000

(c) $100,000

(d) $110,000

Answer: A


Learning Goal: 1



33. A corporation had year end 2004 and 2005 retained earnings balances of $320,000 and $400,000,

respectively. The firm reported net profits after taxes of $100,000 in 2005. The firm paid dividends

in 2005 of _________.

(a) $0

(b) $20,000

(c) $80,000

(d) $100,000

Answer: B


Learning Goal: 1


34. A corporation had a year end 2004 retained earnings balance of $220,000. The firm reported net

profits after taxes of $50,000 in 2005 and paid dividends in 2005 of $30,000. The firm’s retained

earnings balance at year end 2005 was _________.

(a) $240,000

(b) $250,000

(c) $270,000

(d) $300,000

Answer: A


Learning Goal: 1


35. A firm had year end 2004 and 2005 retained earnings balance of $670,000 and $560,000,

respectively. The firm reported net profits after taxes of $100,000 in 2005. The firm paid dividends

in 2005 of _________.

(a) $10,000

(b) $100,000

(c) $110,000

(d) $210,000

Answer: D


Learning Goal: 1


36. Ratios provide a _________ measure of a company’s performance and condition.

(a) definitive

(b) gross

(c) relative

(d) qualitative

Answer: C


Learning Goal: 2



37. _________ analysis involves the comparison of different firms’ financial ratios at the same point in

time.

(a) Time-series

(b) Cross-sectional

(c) Marginal

(d) Quantitative

Answer: B


Learning Goal: 2


38. _________ analysis involves comparison of current to past performance and the evaluation of

developing trends.

(a) Time-series

(b) Cross-sectional

(c) Marginal

(d) Quantitative

Answer: A


Learning Goal: 2


39. The primary concern of creditors when assessing the strength of a firm is the firm’s

(a) profitability.

(b) leverage.

(c) short-term liquidity.

(d) share price.

Answer: C


Learning Goal: 2


40. Present and prospective shareholders are mainly concerned with a firm’s

(a) risk and return.

(b) profitability.

(c) leverage.

(d) liquidity.

Answer: A


Learning Goal: 2



41. To analyze the firm’s financial performance, the following types of ratio analyses EXCEPT

_________ may be used.

(a) time-series analysis

(b) cross-section analysis

(c) combined analysis

(d) marginal analysis

Answer: D


Learning Goal: 2


42. Time-series analysis is often used to

(a) assess developing trends.

(b) correct errors of judgment.

(c) reflect performance relative to some norm.

(d) standardize results.

Answer: A


Learning Goal: 2


43. In ratio analysis, a comparison to a standard industry ratio is made to isolate _________ deviations

from the norm.

(a) positive

(b) negative

(c) any

(d) standard

Answer: C


Learning Goal: 2


44. _________ evidence of the existence of a problem or outstanding management performance is

provided by ratio analysis.

(a) Conclusive

(b) Inconclusive

(c) Complete

(d) Definitive

Answer: B


Learning Goal: 2



45. The analyst should be careful when conducting ratio analysis to ensure that

(a) the overall performance of the firm is not judged on a single ratio.

(b) the dates of the financial statements being compared are the same.

(c) audited statements are used.

(d) the same accounting procedures were used.

(e) all of the above.

Answer: E


Learning Goal: 2


46. The analyst should be careful when evaluating a ratio analysis that

(a) The overall performance of the firm may be judged on a single ratio.

(b) The dates of the financial statements being compared are the same time.

(c) Pre-audited statements are used.

(d) All of the above.

Answer: B


Learning Goal: 2


47. _________ is where the firm’s ratio values are compared to those of a key competitor or group of

competitors, primarily to identify areas for improvement.

(a) Time-series analysis

(b) Benchmarking

(c) Combined analysis

(d) None of the above.

Answer: B


Learning Goal: 2


48. Cross-sectional ratio analysis is used to

(a) correct expected problems in operations.

(b) isolate the causes of problems.

(c) provide conclusive evidence of the existence of a problem.

(d) reflect the symptoms of a possible problem.

Answer: D


Learning Goal: 2



49. In the near term, the important ratios that provide the information critical to the short-run operation

of the firm are

(a) liquidity, activity, and profitability.

(b) liquidity, activity, and common stock.

(c) liquidity, activity, and debt.

(d) activity, debt, and profitability.

Answer: A


Learning Goal: 2


50. One way to negate the effect of inflation on ratio analysis is to value the fixed assets at

(a) book value.

(b) liquidation value.

(c) replacement value.

(d) depreciation.

Answer: C


Learning Goal: 2


51. Inflation can distort

(a) inventory costs.

(b) accumulated depreciation.

(c) interest write-offs.

(d) salaries and wages.

Answer: A


Learning Goal: 2


52. Without adjustment, inflation may tend to cause _________ firms to appear more efficient and

profitable than _________ firms, all else being the same.

(a) large; smaller

(b) older; newer

(c) smaller; larger

(d) newer; older

Answer: B


Learning Goal: 2



53. The following groups of ratios primarily measure risk.

(a) liquidity, activity, and profitability

(b) liquidity, activity, and common stock

(c) liquidity, activity, and debt

(d) activity, debt, and profitability

Answer: C


Learning Goal: 2


54. The _________ ratios are primarily measures of return.

(a) liquidity

(b) activity

(c) debt

(d) profitability

Answer: D


Learning Goal: 2


55. The _________ of a business firm is measured by its ability to satisfy its short-term obligations as

they come due.

(a) activity

(b) liquidity

(c) debt

(d) profitability

Answer: B


Learning Goal: 3


56. _________ ratios are a measure of the speed with which various accounts are converted into sales

or cash.

(a) Activity

(b) Liquidity

(c) Debt

(d) Profitability

Answer: A


Learning Goal: 3



57. The _________ is useful in evaluating credit and collection policies.

(a) average payment period

(b) current ratio

(c) average collection period

(d) current asset turnover

Answer: C


Learning Goal: 3


58. The _________ measures the activity, or liquidity, of a firm’s inventory.

(a) average collection period

(b) inventory turnover

(c) quick ratio

(d) current ratio

Answer: B


Learning Goal: 3


59. The two basic measures of liquidity are

(a) inventory turnover and current ratio.

(b) current ratio and quick ratio.

(c) gross profit margin and ROE.

(d) current ratio and total asset turnover.

Answer: B


Learning Goal: 3


60. The _________ is a measure of liquidity which excludes _________, generally the least liquid

asset.

(a) current ratio; accounts receivable

(b) quick ratio; accounts receivable

(c) current ratio; inventory

(d) quick ratio; inventory

Answer: D


Learning Goal: 3


61. The _________ ratio may indicate the firm is experiencing stockouts and lost sales.




(d) quick

Answer: B



Learning Goal: 3


62. The _________ ratio may indicate poor collections procedures or a lax credit policy.




(d) quick

Answer: C


Learning Goal: 3


63. ABC Corp. extends credit terms of 45 days to its customers. Its credit collection would be

considered poor if its average collection period was

(a) 30 days.

(b) 36 days.

(c) 47 days.

(d) 57 days.

Answer: D


Learning Goal: 3


64. Which of the following ratios is difficult for creditors of a firm to analyze because the data are

usually not available in published financial statements?

(a) operating leverage

(b) average payment period

(c) quick ratio

(d) average age of inventory

Answer: A


Learning Goal: 3


65. _________ are especially interested in the average payment period, since it provides them with a

sense of the bill-paying patterns of the firm.

(a) Customers

(b) Stockholders

(c) Lenders and suppliers

(d) Borrowers and buyers

Answer: C


Learning Goal: 3



66. A firm has a current ratio of 1; in order to improve its liquidity ratios, this firm might

(a) improve its collection practices, thereby increasing cash and increasing its current and quick

ratios.

(b) improve its collection practices and pay accounts payable, thereby decreasing current liabilities

and increasing the current and quick ratios.

(c) decrease current liabilities by utilizing more long-term debt, thereby increasing the current and

quick ratios.

(d) increase inventory, thereby increasing current assets and the current and quick ratios.

Answer: C


Learning Goal: 3


67. As a firm’s cash flows become more predictable,

(a) the current ratio will expand.

(b) the return on equity will increase.

(c) current liabilities will decrease.

(d) current assets will decrease.

Answer: D


Learning Goal: 3


68. If the inventory turnover is divided into 360, it becomes a measure of

(a) sales efficiency.

(b) the average age of the inventory.

(c) sales turnover.

(d) the average collection period.

Answer: B


Learning Goal: 3


69. The _________ is useful in evaluating credit and collection policies.


(b) current ratio


(d) current asset turnover

Answer: C


Learning Goal: 3



70. The two categories of ratios that should be utilized to assess a firm’s true liquidity are the

(a) current and quick ratios.

(b) liquidity and profitability ratios.

(c) liquidity and debt ratios.

(d) liquidity and activity ratios.

Answer: D


Learning Goal: 3


71. A firm with a total asset turnover that is lower than industry standard but with a current ratio which

meets industry standard must have excessive

(a) fixed assets.

(b) inventory.

(c) accounts receivable.

(d) debt.

Answer: A


Learning Goal: 3


72. The following groups of ratios provide the information critical to the short-run operation of the

firm.

(a) liquidity, activity, and profitability

(b) liquidity, activity, and common stock

(c) liquidity, activity, and debt

(d) activity, debt, and profitability

Answer: A


Learning Goal: 3


73. The _________ ratios provide the information critical to the long-run operation of the firm.

(a) liquidity

(b) activity

(c) debt

(d) profitability

Answer: C


Learning Goal: 3



74. A firm with a total asset turnover lower than industry standard may have

(a) excessive debt.

(b) excessive cost of goods sold.

(c) insufficient sales.

(d) insufficient fixed assets.

Answer: C


Learning Goal: 3


75. The _________ ratio measures the proportion of total assets financed by the firm’s creditors.

(a) total asset turnover

(b) fixed asset turnover

(c) current

(d) debt

Answer: D


Learning Goal: 4


76. The _________ ratio measures the firm’s ability to pay contractual interest payments.

(a) times interest earned

(b) fixed-payment coverage

(c) debt

(d) average payment period

Answer: A


Learning Goal: 4


77. The _________ ratio may indicate that the firm will not be able to meet interest obligations due on

outstanding debt.

(a) debt

(b) net profit margin

(c) return on total assets

(d) times interest earned

Answer: D


Learning Goal: 4



78. The higher the value of _________ ratio, the better able the firm is to fulfill its interest obligations.

(a) debt

(b) average collection period

(c) times interest earned

(d) average payment period

Answer: C


Learning Goal: 4


Table 2.1

Balance Sheet Cole Eagan Enterprises

December 31, 2005

Cash $4,500 Accounts Payable $10,000

Accounts Receivable Notes Payable

Inventory Accruals 1,000

Total Current Assets Total Current Liabilities

Net Fixed Assets Long-Term Debt

Total Assets Stockholders’ Equity

Total Liabilities & S.E.

Information (2005 values)

1.

Sales totaled $110,000

2.

The gross profit margin was 25 percent.

3.

Inventory turnover was 3.0.

4.

There are 360 days in the year.

5.

The average collection period was 65 days.

6.

The current ratio was 2.40.

7.

The total asset turnover was 1.13.

8.

The debt ratio was 53.8 percent.

79. Inventory for CEE in 2005 was _________. (See Table 2.1)

(a) $36,667

(b) $32,448

(c) $27,500

(d) $ 9,167

Answer: C



Learning Goal: 4

Topic: Balance Sheet and Activity Analysis


80. Notes payable for CEE in 2005 was _________. (See Table 2.1)

(a) $113,466

(b) $ 52,372

(c) $ 41,372

(d) $ 10,608

Answer: D


Learning Goal: 4


81. Accounts receivable for CEE in 2005 was _________. (See Table 2.1)

(a) $14,056

(b) $19,861

(c) $14,895

(d) $18,333

Answer: B


Learning Goal: 4


82. Net fixed assets for CEE in 2005 were _________. (See Table 2.1)

(a) $45,484

(b) $48,975

(c) $54,511

(d) $69,341

Answer: A


Learning Goal: 4


83. Total assets for CEE in 2005 were _________. (See Table 2.1)

(a) $ 45,895

(b) $124,300

(c) $ 58,603

(d) $ 97,345

Answer: D


Learning Goal: 4


84. Long-term debt for CEE in 2005 was _________. (See Table 2.1)

(a) $30,737

(b) $52,372

(c) $10,608

(d) $41,372

Answer: A



Learning Goal: 4


85. _________ is a term used to describe the magnification of risk and return introduced through the

use of fixed cost financing such as preferred stock and long-term debt.

(a) Financial leverage

(b) Operating leverage

(c) Fixed-payment coverage

(d) The acid-test

Answer: A


Learning Goal: 4


86. When assessing the fixed-payment coverage ratio,

(a) the lower its value the more risky is the firm.

(b) the lower its value, the lower is the firm’s financial leverage.

(c) preferred stock dividend payments can be disregarded.

(d) the higher its value, the higher is the firm’s liquidity.

Answer: A


Learning Goal: 4


87. The _________ is a popular approach for evaluating profitability in relation to sales by expressing

each item on the income statement as a percent of sales.

(a) retained earnings statement

(b) source and use statement

(c) common-size income statement

(d) profit and loss statement

Answer: C


Learning Goal: 5

Topic: Common Size Analysis

88. The _________ indicates the percentage of each sales dollar remaining after the firm has paid for

its goods.

(a) net profit margin

(b) operating profit margin

(c) gross profit margin

(d) earnings available to common shareholders

Answer: C


Learning Goal: 5



89. The _________ measures the percentage of profit earned on each sales dollar before interest and

taxes.





Answer: B


Learning Goal: 5


90. The _________ measures the percentage of each sales dollar remaining after ALL expenses,

including taxes, have been deducted.





Answer: A


Learning Goal: 5


91. The _________ measures the overall effectiveness of management in generating profits with its

available assets.


(b) price/earnings ratio

(c) return on equity

(d) return on total assets

Answer: D


Learning Goal: 5


92. The _________ measures the return on owners’ (both preferred and common stockholders)

investment in the firm.


(b) price/earnings ratio



Answer: C


Learning Goal: 5



93. The _________ ratio is commonly used to assess the owner’s appraisal of the share value.

(a) debt

(b) price/earnings



Answer: B


Learning Goal: 5

Topic: Market Value Analysis

94. Two frequently cited ratios of profitability that can be read directly from the common-size income

statement are

(a) the earnings per share and the return on total assets.

(b) the gross profit margin and the earnings per share.

(c) the gross profit margin and the return on total assets.

(d) the gross profit margin and the net profit margin.

Answer: D


Learning Goal: 5


95. A firm with a gross profit margin which meets industry standard and a net profit margin which is

below industry standard must have excessive

(a) general and administrative expenses.

(b) cost of goods sold.

(c) dividend payments.

(d) principal payments.

Answer: A


Learning Goal: 5


96. A firm with sales of $1,000,000, net profits after taxes of $30,000, total assets of $1,500,000, and

total liabilities of $750,000 has a return on equity of

(a) 20 percent.

(b) 15 percent.

(c) 3 percent.

(d) 4 percent.

Answer: D


Learning Goal: 5



97. The DuPont system merges the income statement and balance sheet into two summary measures of

profitability:

(a) net profit margin and return on total assets.

(b) net profit margin and return on equity.

(c) return on total assets and return on equity.

(d) net profit margin and price/earning ratio.

Answer: C


Learning Goal: 6


98. _________ is used by financial managers as a structure for dissecting the firm’s financial

statements to assess its financial condition.

(a) Statement of cash flows

(b) The DuPont system of analysis

(c) A common-size income statement

(d) Cross-sectional analysis

Answer: B


Learning Goal: 6


99. In the DuPont system, the return on total assets (asset) is equal to

(a) (return on equity) (financial leverage multiplier).

(b) (return on equity) (total asset turnover).

(c) (net profit margin) (fixed asset turnover).

(d) (net profit margin) (total asset turnover).

Answer: D


Learning Goal: 6


100. The modified DuPont formula relates the firm’s return on total assets (ROA) to the

(a) return on equity (ROE).

(b) financial leverage multiplier.

(c) net profit margin.

(d) total asset turnover.

Answer: A


Learning Goal: 6



101. In the DuPont system, the return on equity is equal to

(a) (net profit margin) (total asset turnover).

(b) (stockholders’ equity) (financial leverage multiplier).

(c) (return on total assets) (financial leverage multiplier).

(d) (return on total assets) (total asset turnover).

Answer: C


Learning Goal: 6


102. A firm with a substandard net profit margin can improve its return on total assets by

(a) increasing its debt ratio.

(b) increasing its total asset turnover.

(c) decreasing its fixed asset turnover.

(d) decreasing its total asset turnover.

Answer: B


Learning Goal: 6


103. A decrease in total asset turnover will result in _________ in the return on equity.

(a) an increase

(b) a decrease

(c) no change

(d) an undetermined change

Answer: B


Learning Goal: 6


104. A firm with a substandard return on total assets can improve its return on equity, all else remaining

the same, by

(a) increasing its debt ratio.

(b) increasing its total asset turnover.

(c) decreasing its debt ratio.

(d) decreasing its total asset turnover.

Answer: A


Learning Goal: 6



105. The three summary ratios basic to the DuPont system of analysis are

(a) net profit margin, total asset turnover, and return on investment.

(b) net profit margin, total asset turnover, and return on equity.

(c) net profit margin, total asset turnover, and equity multiplier.

(d) net profit margin, financial leverage multiplier, and return on equity.

Answer: C


Learning Goal: 6


106. The financial leverage multiplier is an indicator of a corporation utilizing

(a) operating leverage.

(b) long-term debt.

(c) total debt.

(d) total assets.

Answer: C


Learning Goal: 6


107. The financial leverage multiplier is an indicator of a corporation utilizing

(a) operating leverage.

(b) financial leverage.

(c) long-term debt.

(d) current liabilities.

Answer: B


Learning Goal: 6


108. An increase in financial leverage will result in _________ in the return on equity.

(a) an increase

(b) a decrease

(c) no change

(d) an undetermined change

Answer: A


Learning Goal: 6



109. A firm with a total asset turnover lower than the industry standard and a current ratio which meets

the industry standard may have

(a) excessive fixed assets.

(b) excessive inventory.

(c) excessive accounts receivable.

(d) excessive debt.

Answer: A


Learning Goal: 6


110. A firm with a total asset turnover lower than the industry standard may have

(a) excessive debt.

(b) excessive cost of goods sold.

(c) insufficient sales.

(d) insufficient fixed assets.

Answer: C


Learning Goal: 6


Table 2.2

Dana Dairy Products Key Ratios

Industry Average

Actual 2004

Actual 2005

Current Ratio 1.3 1.0

Quick Ratio 0.8 0.75

Average collection Period

23 days 30 days

Inventory Turnover 21.7 19

Debt Ratio 64.7% 50%

Times Interest Earned 4.8 5.5

Gross Profit Margin 13.6% 12.0%

Net Profit Margin 1.0% 0.5%

Return on total assets 2.9% 2.0%

Return on Equity 8.2% 4.0%

Income Statement Dana Dairy Products

For the Year Ended December 31, 2005

Sales Revenue $100,000

Less: Cost of Goods Sold 87,000

Gross Profits $13,000

Less: Operating Expenses 11,000

Operating Profits $2,000

Less: Interest Expense 500

Net Profits Before Taxes $1,500


Less: Taxes (40%) 600

Net Profits After Taxes $900

Balance Sheet Dana Dairy Products December 31, 2005

Assets

Cash $ 1,000

Accounts Receivable 8,900

Inventories 4,350

Total Current Assets $14,250

Gross Fixed Assets $35,000

Less: Accumulated Depreciation 13,250

Net Fixed Assets 21,750

Total Assets $36,000

Liabilities & Stockholders’ Equity

Accounts Payable $ 9,000

Accruals 6,675

Total Current Liabilities $15,675

Long-term Debt 4,125

Total Liabilities $19,800

Common Stock 1,000

Retained Earnings 15,200

Total Stockholders’ Equity $16,200

Total Liabilities & Stockholders Equity $36,000

111. The current ratio for Dana Dairy Products in 2005 was _________. (See Table 2.2)

(a) 1.58

(b) 0.63

(c) 1.10

(d) 0.91

Answer: D


Learning Goal: 6


112. Since 2004, the liquidity of Dana Dairy Products _________. (See Table 2.2)

(a) has deteriorated

(b) remained the same

(c) has improved

(d) cannot be determined

Answer: A


Learning Goal: 6


113. The net working capital for Dana Dairy Products in 2005 was _________. (See Table 2.2)

(a) $10,325

(b) $ 1,425

(c) –$ 1,425

(d) $14,250

Answer: C


Learning Goal: 6


114. The inventory turnover for Dana Dairy Products in 2005 was _________. (See Table 2.2)

(a) 43

(b) 5

(c) 20

(d) 25

Answer: C


Learning Goal: 6


115. The inventory management at Dana Dairy Products _________ since 2004. (See Table 2.2)



(c) has improved slightly


Answer: C


Learning Goal: 6


116. The average collection period for Dana Dairy Products in 2005 was (See Table 2.2)

(a) 32.5 days.

(b) 11.8 days.

(c) 25.3 days.

(d) 35.9 days.

Answer: A


Learning Goal: 6



117. If Dana Dairy Products has credit terms which specify that accounts receivable should be paid in

25 days, the average collection period _________ since 2004. (See Table 2.2)



(c) has improved


Answer: A


Learning Goal: 6


118. Dana Dairy Products had a _________ degree of financial leverage than the industry standard,

resulting in _________. (See Table 2.2)

(a) lower; lower return on total assets

(b) lower; lower return on equity

(c) higher; higher return on equity

(d) higher; higher return on total assets

Answer: B


Learning Goal: 6


119. The debt ratio for Dana Dairy Products in 2005 was (See Table 2.2)

(a) 50 percent.

(b) 11 percent.

(c) 55 percent.

(d) 44 percent.

Answer: C


Learning Goal: 6


120. Dana Dairy Products’ gross profit margin was inferior to the industry standard. This may have

resulted from (See Table 2.2)

(a) a high sales price.

(b) the high cost of goods sold.

(c) excessive selling and administrative expenses.

(d) excessive interest expense.

Answer: B


Learning Goal: 6



121. The gross profit margin and net profit margin for Dana Dairy Products in 2005 were (See

Table 2.2)

(a) 13 percent and 0.9 percent, respectively.

(b) 13 percent and 1.5 percent, respectively.

(c) 2 percent and 0.9 percent, respectively.

(d) 2 percent and 1.5 percent, respectively.

Answer: A


Learning Goal: 6


122. The return on total assets for Dana Dairy Products for 2005 was (See Table 2.2)

(a) 0.9 percent.

(b) 5.5 percent.

(c) 25 percent.

(d) 2.5 percent.

Answer: D


Learning Goal: 6


123. The return on equity for Dana Dairy Products for 2005 was (See Table 2.2)

(a) 0.6 percent.

(b) 5.6 percent.

(c) 0.9 percent.

(d) 50 percent.

Answer: B


Learning Goal: 6


124. Using the modified DuPont formula allows the analyst to break Dana Dairy Products return on

equity into 3 components: the net profit margin, the total asset turnover, and a measure of leverage

(the financial leverage multiplier). Which of the following mathematical expressions represents the

modified DuPont formula relative to Dana Dairy Products’ 2005 performance? (See Table 2.2)

(a) 5.6(ROE) 2.5(ROA) 2.24(Financial leverage multiplier)

(b) 5.6(ROE) 3.3(ROA) 1.70(Financial leverage multiplier)

(c) 4.0(ROE) 2.0(ROA) 2.00(Financial leverage multiplier)

(d) 2.5(ROE) 5.6(ROA) 0.44(Financial leverage multiplier)

Answer: A


Learning Goal: 6

Topic: DuPont System Analysis


125. As the financial leverage multiplier increases this may result in

(a) an increase in the net profit margin and return on investment, due to the decrease in interest

expense as debt decreases.

(b) an increase in the net profit margin and return on investment, due to the increase in interest

expense as debt increases.

(c) a decrease in the net profit margin and return on investment, due to the increase in interest

expense as debt increases.

(d) a decrease in the net profit margin and return on investment, due to the decrease in interest

expense as debt decreases.

Answer: C


Learning Goal: 6

Topic: DuPont System Analysis

126. The 2002 law that established the Public Company Accounting Oversight Board (PCAOB) was

called

(a) The McCain-Feingold Act.

(b) The Harkins-Oxley Act.

(c) The Sarbanes-Harkins Act.

(d) The Sarbanes-Oxley Act.

Answer: D


Learning Goal: 1


127. The 2002 Sarbanes-Oxley Act was designed to

(a) limit the compensation that could be paid to corporate CEOs

(b) eliminate the many disclosure and conflict of interest problems of corporations

(c) provide uniform international accounting standards

(d) two of the above

Answer: B


Learning Goal: 1


128. The Public Company Accounting Oversight Board (PCAOB)

(a) is a not-for-profit corporation that oversees auditors of public corporations.

(b) is a not-for-profit corporation that oversees managers of public corporations.

(c) is a for-profit corporation that oversees auditors of public corporations.

(d) is a for-profit corporation that oversees managers of public corporations.

Answer: A


Learning Goal: 1



129. If Nico Corporation has cost of goods sold of $300,000 and inventory of $30,000, then the

inventory turnover is _________ and the average age of inventory is _________.

(a) 36.5; 10

(b) 10; 36.5

(c) 36.0; 10

(d) 10; 36.0

Answer: B


Learning Goal: 3


130. If Nico Corporation has annual purchases of $300,000 and accounts payable of $30,000, then

average purchases per day are _________ and the average payment period is _________.

(a) 36.5; 821.9

(b) 36.0; 833.3

(c) 821.9; 36.5

(d) 833.3; 36.0

Answer: C


Learning Goal: 3


Essay Questions

1. Ag Silver Mining, Inc. has $500,000 of earnings before interest and taxes at the year end. Interest

expenses for the year were $10,000. The firm expects to distribute $100,000 in dividends. Calculate

the earnings after taxes for the firm assuming a 40 percent tax on ordinary income.

Answer:

Earnings before interest and taxes $500,000

Less: Interest 10,000

Earnings before taxes $490,000

Less: Taxes (40%) 196,000

Earnings after taxes $294,000


Learning Goal: 1



2. At the end of 2005, the Long Life Light Bulb Company announced it had produced a gross profit of

$1 million. The company has also established that over the course of this year it has incurred

$345,000 in operating expenses and $125,000 in interest expenses. The company is subject to a 30

percent tax rate and has declared $57,000 total preferred stock dividends.

(a) How much is the earnings available for common stockholders?

(b) Compute the increased retained earnings for 2005 if the company were to declare a $4.25

common stock dividend. The company has 15,000 shares of common stock outstanding.

Answers:

(a) Gross Profits $1,000,000

Less: Operating expenses (345,000)

Operating Profits $ 655,000

Less: Interest (125,000)

Net Profits before taxes $ 530,000

Less: Taxes (30%) (159,000)

Net Profits After Taxes $ 371,000

Less: Preferred Stock Dividend (57,000)

Earnings Available for Common Stock $ 314,000

(b) Earnings Available for Common Stock $ 314,000

Dividend (4.25)(15,000 shares) (63,750)

Increased Retained Earnings $ 250,250


Learning Goal: 1


3. Reliable Auto Parts has 5,000 shares of common stock outstanding. The company also has the

following amounts in revenue and expense accounts.

Sales revenue $ 85,000

General and administrative expense 7,500

Interest expense 3,500

Depreciation expense 5,000

Preferred stock dividends 500

Selling expense 4,000

Cost of goods sold 50,000

Calculate

(a) gross profits.

(b) operating profits.

(c) net profits before taxes.

(d) net profits after taxes (assume a 40 percent tax rate).

(e) cash flow from operations.

(f) earnings available to common stockholders.

(g) earnings per share.


Answers:

(a) Sales revenue $85,000

– cost of goods sold –50,000

Gross profits $35,000

(b) Gross profits $35,000

– operating expenses

Selling expense 4,000

General & adm. expense 7,500


$16,500

Operating profits $18,500

(c) Operating profits $18,500

– interest expense –3,500

Net profits before taxes $15,000

(d) Net profits before taxes $15,000

– taxes (40%) –6,000

Net profits after taxes $9,000

(e) Net profits after taxes $9,000

depreciation expense 5,000

Cash flow from operations $14,000

(f) Net profits after taxes $9,000

– preferred dividends –500

earnings available for C.S. $8,500

(g) Earnings available for C.S. $8,500

______________________ = $1.70/share

# of common shares outstanding

5,000


Learning Goal: 1



4. Colonial Furniture’s net profits before taxes for 2002 totaled $354,000. The company’s total

retained earnings were $338,000 for 2004 year end and $389,000 for 2005 year end. Colonial is

subject to a 26 percent tax rate. How large was the cash dividend declared by Colonial Furniture in

2005?

Answer:


Less: Taxes (26%) 92,040

Net Profits After Taxes $261,960

Retained Earnings (2004) $338,000

Net Profits After Taxes (2005) 261,960

Dividends X

------------------------------ ------------


Dividends $210,960


Learning Goal: 1


5. On December 31, 2004, the Bradshaw Corporation had $485,000 as an ending balance for its

retained earnings account. During 2005, the corporation declared a $3.50/share dividend to its

stockholders. The Bradshaw Corporation has 35,000 shares of common stock outstanding. When

the books were closed for 2005 year end, the corporation had a final retained earnings balance of

$565,000. What was the net profit earned by Bradshaw Corporation during 2005?

Answer:

Dividends ($3.50/share)(35,000 shares)

$122,500


Net Profits After Taxes (2005) X

Dividends 122,500

------------------------------ -----------




Learning Goal: 1



6. The Sunshine Company had a retained earnings balance of $850,000 at the beginning of 2005. By

the end of 2005, the company’s retained earnings balance was $950,000. During 2005, the company

earned $245,000 as net profits after paying its taxes. The company was then able to pay its

preferred stockholders $45,000. Compute the common stock dividend per share in 2005 assuming

10,000 shares of common stock outstanding.

Answer:


Net Profits After Taxes (2005) 245,000

Preferred Stock Dividend (45,000)

Common Stock Dividend X

------------------------------ ------------


Total common stock dividend $100,000

Common stock dividend per share 100,000/10,000 $10


Learning Goal: 1


7. Discuss the limitations of ratio analysis and the cautions which must be taken when reviewing a

cross-sectional and time-series analysis.

Answer: In summarizing a large number of ratios, all aspects of the firm’s activities can be

assessed. However, limitations of ratio analysis must be recognized. A comparison of

current and past ratios may reveal mismanagement. But, the ratio does not give definitive

cause to the problem. Additional investigation is necessary to confirm the possible

problem. The analyst must be cautious of the following points: 1) a single ratio does not

provide sufficient information to judge the overall performance of the firm, 2) the dates of

the financial statements should be the same, 3) audited statements should be used, 4)

similar accounting treatment of comparative data is essential, and 5) inflation and

differing asset ages can distort ratio comparisons.


Learning Goal: 2



8.

Key Financial Data

Dreamscape, Inc. Industry Average

Ratio For the Year Ended For the Year Ended

(% of Sales) December 31, 2004 December 31, 2005

Cost of goods sold 74.5% 70.0%

Gross profits 25.5 30.0

Selling expense 8.0 7.0

Gen. & admin. expense 5.1 4.9

Depreciation expense 2.4 2.0

Total operating expense 15.5 13.9

Operating profits 10.0 16.1

Interest expense 1.4 1.0

Net profits before taxes 8.6 15.1

Taxes 2.4 6.0

Net profits after taxes 5.2 9.1

Income Statement, Dreamscape, Inc. For the Year Ended December 31, 2005

Sales revenue $1,000,000

Less: Cost of goods sold 750,000

Gross profits $ 250,000

Less: Operating expenses

Selling Expense $70,000

Gen. & admin. expense 48,000


Total operating expense $ 138,000

Operating profits $ 112,000

Less: Interest expense $ 20,000

Net profits before taxes $ 92,000

Less: Taxes $ 36,800

Net profits after taxes $ 55,200

Prepare a common-size income statement for Dreamscape, Inc. for the year ended December 31,

2005. Evaluate the company’s performance against industry average ratios and against last year’s

results.


Answer:

Common-Size Income Statement Dreamscape, Inc.


Sales revenue 100%

Less: Cost of goods sold 75%

Gross profits 25%

Less: Operating expenses

Selling Expense 7.0%

Gen. & admin. expense 4.8%

Depreciation expense 2.0%

Total operating expense 13.8%

Operating profits 11.2%

Less: Interest expense 2.0%

Net profits before taxes 9.2%

Less: Taxes 3.68%

Net profits after taxes 5.52%

Dreamscape, Inc. performs significantly below industry average. All profitability ratios

(gross profit margin, operating profit margin, and net profit margin) trail the industry

norms. In 2004 expenses as a percent of sales were high.

Dreamscape, Inc. improved the management of operating expenses in 2005 meeting

industry averages. However, cost of goods sold as a percent of sales increased and is a

full 5 percent above the industry average, further reducing the gross profit margin.

Interest expense is two times the average indicating high cost of debt or a high debt level.

The firm must concentrate on reducing the cost of goods sold and interest expense to

improve performance.


Learning Goal: 6

Topic: Common Size Statement Analysis

9. In an effort to analyze Clockwork Company finances, Jim realized that he was missing the

company’s net profits after taxes for the current year. Find the company’s net profits after taxes

using the following information.

Return on total assets 2%

Total Asset Turnover 0.5

Cost of Goods Sold $105,000

Gross Profit Margin 0.30

Answer: Sales CGS/(1 – GPM) 105,000/(1 – 0.30) $150,000

Total Assets Sales/(Total Asset Turnover)

150,000/0.50 $300,000

Net Profits After Taxes (ROA) (Total Assets)

(0.02) (300,000) $6,000



Learning Goal: 6

Topic: Ratio and Financial Statement Analysis

10. Construct the DuPont system of analysis using the following financial data for Key Wahl Industries

and determine which areas of the firm need further analysis.

Key Financial Data

Key Wahl Industries:

Sales $4,500,000

Net profits after taxes 337,500

Total assets 6,750,000

Total liabilities 3,375,000

Industry Averages:

Total asset turnover 0.71

Debt ratio 33.00%

Financial leverage multiplier 1.50

Return on total assets 6.75%

Return on equity 10.00%

Net profit margin 9.50%

Answer: Ratios for Key Wahl Industries

4,500,000Total asset turnover 0.67

6,750,000

3,375,000Debt ratio 50%

6,750,000

1Financial leverage multiplier 2

1 0.5

337,500ROA 5%

6,750,000

ROE ROA Financial leverage multiplier 10%

337,500Net profit margin 7.5%

4,500,000

DuPont System of Analysis: Key Wahl Industries performs equally to industry averages

according to the return on equity. However, when dissecting the financial data further

into the three key components of the DuPont system (a profit-on-sale, efficiency-of-asset

use, and a use-of-leverage component), some areas of improvement may be highlighted.

Key Wahl Industries has a lower net profit margin and return on total assets than industry

averages. Nevertheless, the firm makes up for the low profit margin through excessive

use of leverage (a 50 percent debt ratio versus 33 percent for the industry). Financial risk

could be reduced resulting in the same return on equity by increasing the net profit

margin and reducing debt.


Learning Goal: 6



11. Given the following balance sheet, income statement, historical ratios and industry averages,

calculate the Pulp, Paper, and Paperboard, Inc. financial ratios for the most recent year. Analyze its

overall financial situation for the most recent year. Analyze its overall financial situation from both

a cross-sectional and time-series viewpoint. Break your analysis into an evaluation of the firm’s

liquidity, activity, debt, and profitability.

Income Statement Pulp, Paper and Paperboard, Inc.


Sales Revenue $2,080,976

Less: Cost of Goods Sold 1,701,000

Gross Profits $379,976

Less: Operating Expenses 273,846

Operating Profits $106,130

Less: Interest Expense 19,296


Less: Taxes (40%) 34,810


Balance Sheet Pulp, Paper and Paperboard, Inc.

December 31, 2005

Assets

Cash $ 95,000

Accounts receivable 237,000

Inventories 243,000

Total current assets $ 575,000

Gross fixed assets 500,000

Less: Accumulated depreciation 75,000

Net fixed assets $ 425,000

Total assets $1,000,000

Liabilities and stockholders’ equity

Current liabilities

Accounts payable $ 89,000

Notes payable 169,000

Accruals 87,000

Total current liabilities $ 345,000

Long-term debt 188,000

Total liabilities $ 533,000

Stockholders’ equity

Common stock 255,000

Retained earnings 212,000

Total stockholders’ equity $ 467,000

Total liabilities and stockholders’ equity

$1,000,000


Historical and Industry Average Ratios

Pulp, Paper and Paperboard, Inc.

Ratio

2003

2004

2005

Industry 2005

Current Ratio 1.6 1.7 — 1.6

Quick Ratio 0.9 1.0 — 0.9

Inventory Turnover 8.1 9.3 — 8.4

Average Collection Period 33 days 37 days — 39 days

Total Asset Turnover 2.3 2.2 — 2.2

Debt Ratio 60% 56% — 58%

Times Interest Earned 2.5 3.5 — 2.3

Gross Profit Margin 21% 19.7% — 20.4%

Operating Profit Margin 4.7% 4.8% — 4.7%

Net Profit Margin 1.8% 1.6% — 1.4%

Return on total assets 4.1% 3.5% — 3.08%

Return on Equity 10.3% 7.9% — 7.3%

Answer:

Historical and Industry Average Ratios Pulp, Paper and Paperboard, Inc.

Ratio

2003

2004

2005

Industry 2005

Current Ratio 1.6 1.7 1.67 1.6

Quick Ratio 0.9 1.0 0.96 0.9

Inventory Turnover 8.1 9.3 7.0 8.4

Average Collection Period 33 days 37 days 41 days 39 days

Total Asset Turnover 2.3 2.2 2.1 2.2

Debt Ratio 60% 56% 53% 58%

Times Interest Earned 2.5 3.5 5.5% 2.3

Gross Profit Margin 21% 19.7% 18.0% 20.4%

Operating Profit Margin 4.7% 4.8% 5.1% 4.7%

Net Profit Margin 1.8% 1.6% 2.5% 1.4%

Return on total assets 4.1% 3.5% 5.2% 3.08%

Return on Equity 0.3% 7.9% 11.1% 7.3%

LIQUIDITY: The liquidity of 3P is on target with the industry standard in 2005 and

shows no trend since 2000.

ACTIVITY: Inventory and accounts receivable management has deteriorated since 2004

and is inferior when compared to the industry standard. The low inventory turnover may

be caused by overstocking and/or obsolete inventories. The high average collection

period may have resulted from poor collections procedures. Further investigation is

necessary to determine the cause of the variances.


DEBT: 3P has less debt than the industry average. The trend since 2003 has been toward

reducing the debt ratio. The firm, therefore, is subject to less financial risk than the

average firm in the industry.

PROFITABILITY: Although the gross profit margin is inferior to the industry average,

the operating and net profit margin far exceed the standards, boosting return on total

assets and return on equity. The trend in the gross profit margin is unfavorable and may

either be caused by a slide in product prices or an escalation in cost of sales. The cause of

the poor gross profit margin should be investigated.

Overall, the firm needs to focus attention on inventory and accounts receivable

management and the cause of the poor gross profit margin. In general, the firm is in good

financial condition.


Learning Goal: 6

Topic: Complete Ratio Analysis

12. Complete the balance sheet for General Aviation, Inc. based on the following financial data.

Balance Sheet General Aviation, Inc.

December 31, 2005

Assets

Cash $ 8,005

Marketable securities —

Accounts receivable —

Inventories —

Total current assets —

Gross fixed assets —

Less: Accumulated depreciation $50,000

Net fixed assets —

Total assets —

Liabilities and Stockholders’ Equity

Accounts payable $28,800

Notes payable —

Accruals $18,800

Total current liabilities —

Long-term debts —

Total liabilities —


Preferred stock 2,451

Common stock at par 30,000

Paid-in capital in excess of par 6,400


Total stockholders’ equity —


—


Key Financial Data (2005)

1.

Sales totaled $720,000.

2.

The gross profit margin was 38.7 percent.

3.

Inventory turned 6 times.

4.

There are 360 days in a year.

5.

The average collection period was 31 days.

6.

The current ratio was 2.35.

7.

The total asset turnover was 2.81.

8.

The debt ratio was 49.4 percent.

9.

Total current assets equal $159,565.

Answer:

Balance Sheet General Aviation, Inc.

December 31, 2005

Assets

Cash $ 8,005

Marketable securities 16,000

Accounts receivable 62,000

Inventories 73,560

Total current assets $159,565

Gross fixed assets 146,663

Less: Accumulated depreciation $50,000

Net fixed assets $ 96,663

Total assets $256,228

Liabilities and Stockholders’ Equity

Current liabilities

Accounts payable $28,800

Notes payable 20,300

Accruals $18,800

Total current liabilities $67,900

Long-term debts 58,677

Total liabilities $126,577


Preferred stock 2,451

Common stock at par 30,000


Paid-in capital in excess of par 6,400


Total stockholders’ equity $129,651


$256,228


Learning Goal: 6

Topic: Ratio and Financial Statement Analysis

Full file at ://fratstock.eu/sample/Test-Bank-Principles... · Full file at Chapter 2 Financial...

Documents

Transcript of Full file at ://fratstock.eu/sample/Test-Bank-Principles... · Full file at Chapter 2 Financial...